On August 29, 2023, the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (FRB) and the Office of the Comptroller of the Currency (OCC and, together with the FDIC and the FRB, collectively, the Banking Agencies) issued a package of proposed rules and guidance aimed at improving the resolvability of large and midsize, primarily regional, banks that are not subject to the regime applicable to global systemically important banks (GSIBs). Although many features reflected longstanding policy concerns,1 echoes of recent turmoil in the banking sector—culminating in the failure and resolution of Silicon Valley Bank, Signature Bank and First Republic Bank—are unmistakable throughout the proposals.
In this post, we summarize key aspects of the proposed rules and guidance, highlighting potential challenges and likely focal points of forthcoming public debate. Although these resolution-related proposals are distinct from the capital rules proposed just weeks earlier on July 27, 2023, they reflect similar priorities – most notably, addressing apparent gaps in the US regulatory framework that may have contributed to bank failures earlier in the year.
Specifically, below we discuss:
- A joint proposal requiring that insured depositary institutions (IDIs) with consolidated assets exceeding $100 billion, as well as their holding companies and certain affiliates, maintain a minimum amount of outstanding long-term debt capable of absorbing losses in the event of a failure (the LTD Proposal).
- An FDIC proposed rule to revise and enhance existing resolution plan requirements for midsized banks (the IDI Resolution Plan Proposal).
- Proposed guidance from the FDIC and FRB concerning the resolution plans required of large US and foreign banking organizations that are not G-SIBs (the Resolution Plan Guidance Proposal).
As with the proposed capital rules released in July (discussed in our previous post), the comment period for each of these proposals runs until November 30, 2023. We expect robust debate as these important measures take shape and will provide further updates as appropriate.
The LTD Proposal
If implemented, the LTD Proposal would apply long term debt requirements to the following entities:
- Bank holding companies (BHCs) and savings and loan holding companies (SLHCs) that are subject to the FRB’s Category II, III or IV enhanced prudential standards (also referred to as the “tailoring” categories2) as well as non-GSIB US intermediate holding companies of foreign banking organizations in Category II, III, or IV (Covered IHCs);
- IDIs with consolidated assets exceeding $100 billion that are consolidated subsidiaries of a Category II, III or IV BHC, SLHC, or Covered IHC;3 and
- IDIs with average consolidated assets for the four most recent calendar quarters equal to or exceeding $100 billion that are not consolidated subsidiaries of a Category II, III or IV BHC, SLHC, or Covered IHC.4
Eligible Debt Characteristics
The characteristics of eligible long-term debt vary by entity. Generally, domestic holding companies subject to the LTD Proposal (i.e., a Category II, III or IV BHC or SLHC) must issue the debt to third parties, while some Covered IHCs may be permitted to issue the debt to a foreign parent or affiliate or to external third parties (with others required to issue debt to a foreign parent or affiliate). For IDIs that are consolidated subsidiaries of a Category II, III or IV BHC, SLHC, or Covered IHC, eligible debt must be issued to a parent holding company or another eligible affiliate that is consolidated for accounting purposes with its parent; issuance to external parties is not permitted. IDIs that are not consolidated subsidiaries of a Category II, III or IV BHC, SLHC, or Covered IHC may be permitted to issue the debt either internally or to a third party.
Debt securities will qualify as eligible debt under the LTD Proposal, only if they meet certain characteristics designed to ensure they will function to absorb losses in a resolution scenario. Namely, the debt instruments must:
- have a maturity date at least one year after the date of issuance;5
- be governed by US or state law;
- be contractually subordinated to deposits and general unsecured creditors of the issuer; and
- (if issued to third parties) have a minimum denomination of at least $400,000.
Additionally, eligible debt instruments may not:
- be secured or guaranteed by the covered IDI or a subsidiary or affiliate of the covered IDI or supported by any other credit enhancement;
- provide for contractual rights to accelerate payment of principal or interest, except for rights exercisable on dates specified in the relevant instrument or in the event of (i.) a receivership, insolvency, liquidation, or similar proceeding of the issuer or (ii.) failure by the issuer to pay principal or interest when due and payable that is not cured within 30 days;
- contain credit-sensitive features, such as an interest rate that is reset periodically based on the issuer’s credit condition;
- be structured notes; or
- be convertible into, or exchangeable for, equity of the issuer.
Importantly, the LTD Proposal provides for grandfathering of existing debt that complies with a subset of eligibility criteria (most notably excluding the requirement of limited acceleration rights and contractual subordination to general unsecured creditors).
The amount of long-term debt a covered entity must issue and maintain also varies under the LTD Proposal, generally in accordance with the so-called “capital refill” framework. Under this framework, a banking entity is required to maintain eligible long-term debt that, in the event it enters resolution, would be sufficient to replenish capital to at least the amount required to meet the entity’s minimum leverage capital requirements and common equity tier 1 risk-based capital requirements (plus the capital conservation buffer, if applicable).
According to the Banking Agencies, this approach will ordinarily require a covered entity to maintain long-term debt equal to the greater of: 6% of its total risk-weighted assets, 2.5% of its total leverage exposure (if applicable), and 3.5% of its average total consolidated assets.6 We note, however, that the Banking Agencies expressly reserve their authority to increase the long-term debt requirements applied to any particular entity based on its perceived risk profile.
The LTD Proposal’s requirements, if adopted, would come into full effect three years after the date a covered entity first becomes subject to the requirements. However, the requirements gradually phase in during the three-year period. Specifically, entities in scope would be required to put in place 25% of the required amount of debt within one year, 50% of the of the required amount of debt within the second year and 100% of the required amount of debt by the end of the third year.
Initial Observations and Takeaways
In the issuing release and in separate statements, policymakers have been consistent in stressing that the LTD Proposal would bolster the resolvability of covered entities, creating a buffer of capital that would be available to absorb losses. This buffer would likely increase the available resolution strategies and consequently reduce the cost of failures to the Deposit Insurance Fund.
The Banking Agencies make plain that implementing these requirements will be expensive for covered entities, acknowledging the cost of funding for a covered entity will increase and cause a decline in aggregate net interest margins as the covered entity replaces cheaper sources of funding (e.g., uninsured deposits) with eligible long-term debt at the required levels. Although the Banking Agencies suggest that this cost is far outweighed by the benefits to financial stability, we expect this to be a topic of considerable discussion in the coming weeks.
We also expect robust debate on the question of whether it is necessary in a consolidated banking group to impose long-term debt requirements at both the holding company level and at the IDI level. To this end, FDIC Vice Chairman Travis Hill issued a statement emphasizing that, because most banking organizations that will face requirements under the LTD Proposal hold the vast majority of their assets at the IDI level, the long term debt requirement shall be applied only at that level.
Another open question concerns whether a long-term debt requirement calibrated according to the capital refill framework, which is typical of single point of entry (SPOE) resolution strategies, is the correct approach for domestic banks that, unlike GSIBs, have mostly adopted a multiple point of entry (MPOE) resolution strategy. Again, we expect substantial debate on this point during the comment period.
IDI Resolution Plan Proposal
The IDI Resolution Plan Proposal concerns requirements for the resolution plans IDIs are obligated to file periodically under the FDI Act.
The current rules apply to IDIs with $50 billion or more in total assets and were first issued in 2012.7 Following numerous clarifications and guidance in the intervening years, the FDIC issued a moratorium in 2018, pausing the filing requirements until further notice (the Moratorium). The agency lifted the Moratorium in January 2021, but only with respect to IDIs with more than $100 billion in total assets; the Moratorium remains in place for entities with between $50 billion and $100 billion in assets.
The IDI Resolution Plan Proposal would create two filing groups, one comprising IDIs with $100 billion or more in total assets (the Group A IDIs) and one comprising IDIs with at least $50 billion but less than $100 billion in total assets (the Group B IDIs).
Group A IDIs would be required to submit complete resolution plans every two years, rather the current three-year cycle, and to provide a limited interim supplement in non-filing years. Among other changes as compared to current requirements, the IDI Resolution Plan Proposal would disallow Group A IDIs from relying on strategies that assume an FDIC-arranged sale and would instead require plans contemplating a bridge bank and subsequent resolution.
The IDI Resolution Plan Proposal would permit Group B IDIs to submit more limited plans – and to do so in what the FDIC describes as an “informational filing.” Among other differences, Group B IDIs would not be required to include a resolution strategy assuming the establishment and subsequent dissolution of a bridge bank.
Although Group B IDIs would face fewer requirements than their counterparts in Group A, the incremental burdens they face are material. First, these banks will become subject to a filing obligation that has been suspended entirely for five years. Second, as Vice Chairman Hill explained, preparing even “informational filings” of this sort will require a significant undertaking. For this reason, Vice Chairman Travis Hill described the proposal as effectively imposing the same requirements on both sets of banks.
A controversial feature of the IDI Resolution Plan Proposal is that it would require both Group A IDIs and Group B IDIs to engage far more extensively with the FDIC than is currently required – to demonstrate their resolution capabilities and the “credibility” of their plans. As a result, agency personnel would likely need and could assert the right to access bank information and personnel more frequently, and to a greater degree, than at present. In fact, the IDI Resolution Plan proposal expressly establishes that, in the context of capabilities testing, the FDIC may require an IDI to demonstrate any capability described in the resolution plan submission or required under the rules.
Another notable feature of the IDI Resolution Plan Proposal relates to its enforcement mechanism. The proposal would codify a “credibility” standard and expressly authorize enforcement actions against any IDI that fails to meet it.
Initial Observations and Takeaways
The IDI Resolution Plan Proposal was released over expressions of concern, and dissenting statements, from FDIC Vice Chairman Travis Hill and Director Jonathan McKernan.8 This continues a recent trend, also evident when the capital rules were released in July, of banking regulators taking the unusual step of publicly expressing internal debates and disagreements.
One of the criticisms relates to fundamental questions about the effectiveness of resolution planning as a tool for enhancing the likelihood of successful bank resolutions. Vice Chairman Hill stressed that, although he believes periodic resolution plans can provide valuable high-level information to help the FDIC, he appears to believe that ongoing organic engagement with firms may be preferable to the submission and review of static resolution plans. Put differently, Vice Chairman Hill seems to take a view that more effective, and regular, supervisory discussions regarding resolution could be more valuable than the current regime based on written submissions.
Director McKernan, on the other hand, questioned the FDIC’s authority to enforce requirements in the IDI Resolution Plan Proposal at all. In his view, the FDIC’s powers with respect to resolution plans are not rooted in the Dodd-Frank Act, but rather in authorities that predate that legislation, and the proposal would impose requirements that are beyond the powers granted to the FDIC in those authorities. Doing so, he contends, would require statutory authority beyond what the FDIC currently possesses.
Separate from these debates with the agency, we expect public comments to address a more specific issue presented by the IDI Resolution Plan Proposal – the timeframe for compliance. The release suggests that the FDIC will require half of the Group A IDIs to submit resolution plans under the new rule as soon as after 270 days from the effective date of a final rule. Many observers believe that additional time would be necessary for most covered entities to come into compliance.
Proposed Guidance on Resolution Plans Submitted Pursuant to Section 165(d) of the Dodd-Frank Act
The final item released on August 29, 2023 was the Resolution Plan Guidance Proposal. It consists of proposed guidance regarding resolution plan requirements under Section 165(d) of the Dodd-Frank Act and implementing rules, which apply to Category II and III banking organizations based in the US (Domestic Triennial Full Filers) and in other jurisdictions (Foreign Triennial Full Filers). The Resolution Plan Guidance Proposal builds on guidance proposed for US GSIBs in 20199 and for a subset of Foreign Triennial Full Filers in 202010. According to the preamble, it reflects regulators’ experience reviewing resolution plans submitted in previous cycles as well as the banking distress and failures in the Spring of 2023.
The stated purpose of the Resolution Plan Guidance Proposal is to clarify the agencies’ expectations with respect specific aspects of resolution plans to be submitted by covered entities. These include expectations regarding, among other topics:
- Capital – with a focus on the appropriate positioning of capital and other loss-absorbing instruments methodology and methods for calculating how much capital may be needed to support material entities in a resolution scenario.
- Liquidity – including (i.) adequacy and estimation of the liquidity needs material entities will face in order to remain open and operating in resolution for SPOE strategies; and (ii.) liquidity capabilities necessary for MPOE strategies.
- Governance mechanisms – including how they should be triggered prior to, and promptly in connection with, the execution of a resolution strategy (other than a MPOE strategy with respect to Domestic Triennial Full Filers);
- The development and maintenance of effective operational capabilities to support and enable the execution of a firm’s resolution strategy – including with respect to payment, clearing and settlement activities, collateral, management information systems, shared and outsourced services, and access to and use of the Discount Window;
- Legal entity rationalization and separability – with a focus on the need for the relevant entities to identify operations that could be sold or transferred in a resolution to provide meaningful optionality;
- Derivatives – specifically, whether the agencies should provide guidance on derivatives and trading activities for entities that utilize an SPOE resolution strategy; and
- Assumptions – specifically, establishing that covered entities in their resolution plans should not assume that the systemic risk exception to the least-cost test would be used with respect to a material IDI part of the banking group requiring resolution under the FDI Act.
Initial Observations and Takeaways
Among the more surprising aspects of the Resolution Plan Guidance Proposal is the fact that, although all of the entities to which it is directed have elected an MPOE strategy, the proposal focuses predominantly on expectations for SPOE strategies. The choice to analyze both SPOE strategies and MPOE strategies in the Resolution Plan Guidance Proposal generally reflects the Banking Agencies’ preferred approach of neutrality as between the two models. However, the increased focus on SPOE strategies, coupled with the concurrent release of the LTD Proposal, may lead Category II and III entities to wonder whether the Banking Agencies wish to see more SPOE strategies – and how that may affect the assessment of resolution plan submissions.